FM Financial Management

A. Financial management function

Financial management is concerned with three decisions: investment (what assets to acquire), financing (how to raise the money) and dividend (how much to return to shareholders). The usual primary objective of a company is to maximise the wealth of its shareholders, shown through the share price and dividends. This is balanced against other objectives, such as survival, growth, market share, profit, social responsibility and the interests of other stakeholders. The financial objectives are linked to the corporate strategy: the strategy sets the direction and the financial objectives, such as earnings per share growth and return on capital employed, translate it into measurable targets.

Stakeholders include shareholders, lenders, employees, customers, suppliers, government and the community. Their objectives can conflict, and the interests of managers, who run the company, and shareholders, who own it, can differ (the agency problem). It can be reduced by monitoring, by incentives such as share options and performance-related pay, and by good corporate governance. Incentive schemes can lead to short-term behaviour or manipulation of results, so they must be designed carefully.

Not-for-profit organisations have objectives such as providing services, so they use value for money (economy, efficiency and effectiveness) and measure outputs, quality and the use of funds. Their financial constraints include fixed funding, and the interests of funders and beneficiaries.

Key terms

• Agency problem: The conflict between the interests of managers and the owners they act for.
• Shareholder wealth: The value of the shares plus the dividends paid.
• Value for money: The combination of economy, efficiency and effectiveness.

Study tip: For objectives questions, always say how an objective could conflict with another and how the conflict can be managed.

Practice questions for section A

B. Financial management environment

The economic environment affects businesses through economic growth, inflation, interest rates, exchange rates and government policy. Fiscal policy uses taxation and public spending, and monetary policy uses interest rates and the money supply. Governments also use regulation and competition policy. Businesses need to understand how these affect demand, costs and their cost of finance, and how a change in policy, such as higher interest rates, affects borrowing costs and investment returns.

Financial markets bring together those with surplus funds and those who need funds. Capital markets deal with long-term finance, such as shares and bonds, and money markets deal with short-term finance and lending of up to a year. Financial intermediaries, such as banks, pool savings and lend them, and they manage risk and provide liquidity. A stock exchange allows companies to raise capital and gives investors a market in which to trade shares. Primary markets are where new securities are issued and secondary markets are where existing securities are traded.

Money markets provide short-term finance and a place to invest surplus cash. Their instruments include treasury bills, certificates of deposit, commercial paper, bankers' acceptances and inter-bank lending, and they help businesses to manage liquidity and short-term trade finance.

Key terms

• Capital market: A market for long-term finance, such as shares and bonds.
• Money market: A market for short-term borrowing and lending.
• Financial intermediary: An institution, such as a bank, that channels funds between savers and borrowers.

Study tip: Match each instrument to the market and the term: short-term is money market and long-term is capital market.

Practice questions for section B

C. Working capital management

Working capital is current assets less current liabilities. Managing it means keeping enough liquidity to meet obligations while avoiding unnecessary investment in inventories and receivables. The working capital cycle (or cash operating cycle) is the time between paying for materials and receiving cash from customers. It is the inventory holding period plus the receivables collection period less the payables payment period. A shorter cycle releases cash. Overtrading occurs when a business expands faster than its working capital can support, and it shows as rapid growth in revenue, falling liquidity ratios, growing payables and an increasing overdraft.

Inventory management uses models such as the economic order quantity and just in time to minimise the total cost of ordering and holding. Receivables are managed by assessing the creditworthiness of customers, setting credit terms and limits, collecting amounts due, and considering early settlement discounts, factoring and invoice discounting. The cost of an early settlement discount is shown as an annual rate: (1 + discount / (100 - discount)) raised to the power of 365 divided by the days of credit given up, less 1. Payables are managed by taking the credit available and not damaging relations with suppliers. Cash is managed by forecasting, investing surpluses, and using models such as the Baumol model, which finds the best amount to transfer from investments to cash, and the Miller-Orr model, which sets control limits for cash balances when cash flows are variable.

Funding strategies. Permanent current assets and non-current assets should be matched with long-term finance, and fluctuating current assets with short-term finance. A conservative policy uses more long-term finance, which is less risky but more costly, and an aggressive policy uses more short-term finance, which is cheaper but riskier. A moderate (matching) policy sits between them. The level of working capital needed depends on the nature of the business, its growth and its operating cycle.

Worked figures

Operating cycle: inventory holding period 60 days, receivables 45 days and payables 40 days give a cycle of 60 + 45 - 40 = 65 days.

Baumol model: annual cash needs of $1,000,000, a cost of $50 for each transfer and an interest rate of 5 percent give an optimal transfer of the square root of (2 x 50 x 1,000,000 / 0.05) = $44,721.

Key terms

• Cash operating cycle: Inventory days plus receivables days less payables days.
• Overtrading: Expanding faster than working capital can support.
• Factoring: Selling receivables to a finance company or handing it the collection of debts.

Study tip: Draw the working capital cycle on a line first. It makes the calculation much easier.

Practice questions for section C

D. Investment appraisal

The main techniques are net present value (NPV), internal rate of return (IRR), payback, discounted payback and accounting rate of return. NPV discounts the relevant cash flows at the cost of capital, and a positive NPV adds to shareholder wealth. IRR is the rate at which NPV is zero. Payback measures how quickly the investment is recovered, which is useful for liquidity and risk, but ignores later cash flows. Modified IRR deals with some problems of IRR, such as multiple rates and the reinvestment assumption. Only relevant cash flows are included: future, incremental, cash flows, with no sunk costs and no depreciation.

Inflation and tax. Money (nominal) cash flows should be discounted at the money cost of capital, and real cash flows at the real cost of capital. The money rate is (1 + real rate) x (1 + inflation) - 1. The two methods give the same answer. Tax affects the cash flows. Capital allowances reduce taxable profit, and their value is the allowance multiplied by the tax rate, received when the tax is paid (often with a one-year lag). Working capital needs are included as cash outflows when they arise and recovered at the end.

Risk and uncertainty. Sensitivity analysis tests how far a variable can change before the NPV becomes zero, and expected values weight outcomes by their probabilities. Other approaches are simulation and adjusting the discount rate or payback period for risk. Sensitivity analysis does not give probabilities, and it looks at one variable at a time.

Specific decisions. A lease or buy decision compares the cost of leasing with the after-tax cost of borrowing to buy, and discounts at the after-tax cost of debt. Asset replacement decisions for assets with different lives use the equivalent annual cost (EAC), which is the present value of the costs divided by the annuity factor for the life, and the lowest EAC is chosen. Under single-period capital rationing, where capital is limited, divisible projects are ranked by the profitability index (NPV divided by the investment), and indivisible projects are compared by testing combinations.

Worked figures

Inflation: a real rate of 5 percent and inflation of 3 percent give a money rate of 1.05 x 1.03 - 1 = 8.15%. A project with real cash flows of $40,000 a year for 3 years and a cost of $100,000 has a real NPV of 40,000 x 2.7232 - 100,000 = $8,930.

Tax allowance: an asset costing $100,000 gets a 25 percent reducing balance allowance in year 1 of $25,000. At a tax rate of 30 percent, the tax saving is $7,500.

EAC: machine A costs $20,000 and lasts 4 years, and machine B costs $14,000 and lasts 3 years. At 10 percent the EAC of A is 20,000 / 3.1699 = $6,309 and of B is 14,000 / 2.4869 = $5,630, so B is cheaper.

Key terms

• Real rate: A rate that excludes inflation.
• Equivalent annual cost: The present value of the costs of an asset divided by the annuity factor for its life.
• Profitability index: NPV per unit of capital invested, used to rank divisible projects.
• Capital rationing: A limit on the capital available for investment.

Study tip: Do not mix real cash flows with money discount rates, or money flows with real rates. It is the most common error.

Practice questions for section D

E. Business finance

Sources of finance. Equity is raised by retained earnings, a rights issue, a placing or a public offer, and by listing on a stock exchange. Debt includes bank loans, bonds and debentures, leasing, and convertible debt. Short-term finance includes overdrafts, trade credit and factoring. Internal sources include retained earnings and better working capital management. Dividend policy and the financing decision are linked: paying a high dividend leaves less to retain. Equity is riskier for the investor and so it costs more than debt, and debt has a lower cost because interest is paid before dividends, it ranks higher in the creditor hierarchy, and interest is normally tax deductible. High gearing increases the financial risk and the volatility of returns to shareholders.

Islamic finance. Islamic finance does not allow riba (interest). Returns are made through trade, leasing or sharing in profit and loss. The instruments in the syllabus are murabaha (trade credit, in which the financier buys an item and sells it to the customer at a mark-up), ijara (lease finance), mudaraba (equity finance in which one party provides the money and the other the expertise, and profits are shared), sukuk (debt-like securities backed by assets) and musharaka (a partnership used for venture capital, with the profit and losses shared). No calculations are required.

Cost of capital. The cost of equity can be found using the dividend valuation model, in which the share price is the next dividend divided by the cost of equity less the growth rate, or using the capital asset pricing model (CAPM): cost of equity = risk-free rate + beta x (market return - risk-free rate). Beta measures the systematic risk of the share compared with the market. The cost of debt is the internal rate of return of the cash flows of the debt, and for irredeemable debt the after-tax cost is interest x (1 - tax rate) divided by the market price. The weighted average cost of capital (WACC) weights the costs of equity and debt by their market values. WACC can be used as the discount rate for projects that have the same business risk and the same financial risk as the existing company.

Capital structure. Traditional theory says that there is an optimal gearing at which the WACC is lowest. Modigliani and Miller, without tax, say that the value of the company and the WACC are not affected by gearing, and with tax say that value rises with gearing because of the tax shield on debt. In practice, costs of financial distress, agency costs and the limits on borrowing mean that gearing is limited. Small and medium-sized entities find it harder to raise finance, because of the lack of security and track record, and sources include bank loans, trade credit, leasing, venture capital, business angels and government schemes.

Worked figures

CAPM: a risk-free rate of 4 percent, a market return of 9 percent and a beta of 1.2 give a cost of equity of 4% + 1.2 x (9% - 4%) = 10.0%.

Dividend valuation: the last dividend is $0.50, growth is 4 percent and the cost of equity is 10 percent. The share price is 0.50 x 1.04 / (0.10 - 0.04) = $8.67.

WACC: equity makes up 60 percent of the finance at a cost of 10 percent, and debt 40 percent at an after-tax cost of 5 percent. WACC = 0.6 x 10% + 0.4 x 5% = 8.0%.

Cost of debt: 6 percent irredeemable debt trades at $80 per $100 nominal and the tax rate is 25 percent. After-tax cost = 6 x (1 - 0.25) / 80 = 5.625%.

Key terms

• Riba: Interest, which is prohibited in Islamic finance.
• Beta: A measure of a share's sensitivity to market movements.
• WACC: The average cost of a company's finance, weighted by market value.
• Sukuk: Asset-backed Islamic securities that give investors a share in the returns of the assets.

Study tip: For WACC, use market values for the weights, not book values.

Practice questions for section E

F. Business valuations

Valuations are needed for acquisitions, flotation, disposals, divorce of businesses, and to measure the performance of managers. There is no single right value, and the method depends on the purpose and the information available. Asset-based methods value the net assets, either at book value, replacement cost or net realisable value, and ignore future earnings and intangible items. Income-based methods use the price earnings ratio (P/E): value = earnings multiplied by a suitable P/E ratio (from a similar quoted company, adjusted for size, risk and marketability). The earnings yield is the inverse. Cash flow based methods discount the expected future free cash flows or dividends. The dividend valuation model values a share at the next dividend divided by the cost of equity less the growth rate.

The valuation of debt and other financial assets uses discounted cash flows at the investor's required return, so a bond's value is the present value of the interest and the redemption value. Irredeemable debt is worth the annual interest divided by the required yield.

The efficient market hypothesis (EMH) says that share prices reflect available information. In the weak form, prices reflect past price information, so technical analysis cannot give extra returns. In the semi-strong form, prices reflect all public information, so fundamental analysis cannot give extra returns. In the strong form, prices reflect all information, public and private, so even insider information cannot be used to gain extra returns. Evidence suggests that markets are broadly efficient in the weak and semi-strong forms but not in the strong form. In practice, the valuation of shares is affected by market sentiment, the information available, and the costs of trading.

Worked figures

P/E: earnings per share are $0.40 and a suitable P/E ratio is 12. The share value is 0.40 x 12 = $4.80.

Key terms

• Price earnings ratio: Share price divided by earnings per share.
• Semi-strong form efficiency: Prices reflect all publicly available information.
• Free cash flow: Cash available to the providers of finance after investment needed to maintain the business.

Study tip: State the purpose and method of every valuation. Different purposes can give different values.

Practice questions for section F

G. Risk management

Businesses face risks such as exchange rate risk (transaction risk on trade, translation risk on consolidating foreign operations and economic risk to competitiveness), interest rate risk (gap exposure between assets and liabilities that reprice at different times, and basis risk, where two rates do not move together) and others such as credit and liquidity risks. Risk management means identifying the risk, measuring it, deciding the policy and hedging where it is cost-effective.

Exchange rates are affected by the balance of payments, inflation and interest rates. Purchasing power parity (PPP) says that the exchange rate will change to reflect differences in inflation: expected spot rate = current spot x (1 + inflation in the quoted currency) / (1 + inflation in the base currency). Interest rate parity (IRP) says that the forward rate reflects differences in interest rates: forward = spot x (1 + interest rate of the quoted currency) / (1 + interest rate of the base currency). The four-way equivalence links these with the expected spot rate and the Fisher effect.

Interest rates are affected by the structure of rates (yield curves), expectations theory (long rates reflect expected future short rates), liquidity preference theory (investors want a premium for lending long) and market segmentation (different markets for different terms).

Hedging foreign currency risk. Simple methods include invoicing in your own currency, netting (offsetting receipts and payments in the same currency), matching (using receipts to pay costs in the same currency), and leading and lagging (paying early or late depending on expected rate movement). Forward contracts fix the rate for a future date. A money market hedge borrows or deposits in the foreign currency, and so locks in the rate using today's spot rate and interest rates. Asset and liability management reduces the exposure by matching assets and liabilities in the same currency.

Hedging interest rate risk. Traditional methods are matching and smoothing, and asset and liability management. A forward rate agreement (FRA) fixes the interest rate for a future period. The syllabus also asks you to identify the main interest rate derivatives (such as futures, options and swaps) and to explain how they are used, but no numerical questions are set on them.

Worked figures

Interest rate parity: the spot rate is 100 foreign currency units per $1, the annual interest rate is 8 percent in the foreign currency and 3 percent in dollars. The one-year forward rate is 100 x 1.08 / 1.03 = 104.85.

Purchasing power parity: with inflation of 6 percent in the foreign currency and 2 percent in dollars, the expected spot rate in a year is 100 x 1.06 / 1.02 = 103.92.

Key terms

• Transaction risk: The risk that exchange rates change between agreeing and settling a transaction.
• Forward contract: An agreement to buy or sell currency at a fixed rate on a future date.
• Forward rate agreement: An agreement that fixes the interest rate for a future period.
• Basis risk: The risk that two interest rates do not move together.

Study tip: Know the formula pattern for PPP and IRP: quoted currency on top, base currency underneath.

Practice questions for section G